Robert J. Rhee, a Price Theory of Legal Bargaining: an Inquiry Into the Selection of Settlement and Litigation Under Uncertainty

• Publication year: 2007

A PRICE THEORY OF LEGAL BARGAINING: AN INQUIRY INTO THE SELECTION OF SETTLEMENT AND LITIGATION UNDER UNCERTAINTY

Robert J. Rhee^*

INTRODUCTION .............................................................................................. 620

I. ASSUMPTIONS ..................................................................................... 625

II. STANDARD ECONOMIC MODEL OF BARGAINING ................................ 629

A. Transaction Cost Efficiency ....................................................... 629

B. Selection Theory of Trial and Settlement ................................... 632

C. Assumptions of the Standard Model ........................................... 635

III. CRITIQUE OF THE STANDARD MODEL ................................................ 638

A. Theories of Probability ............................................................... 638

B. Probability and Legal Application ............................................. 646

C. Weight, Variance, and Confidence ............................................. 653

D. Random Walk Down Litigation Lane ......................................... 661

IV. A PRICE THEORY OF LEGAL BARGAINING .......................................... 666

A. Cost-Benefit Analysis ................................................................. 666

B. Intrinsic Value, Noise, and Litigation Risk ................................ 668

C. Variance, Probability, and Risk Preference ............................... 678

D. Selection of Settlement and Trial ................................................ 686

CONCLUSION .................................................................................................. 691

ABSTRACT

Conventional wisdom says that economic surplus is created when the cost of litigation is foregone in favor of settlement-a theory flowing from the Coase Theorem. The cost-benefit analysis weighs settlement against the expected value of litigation net of transaction cost. This calculus yields the normative proposition that settlements are superior and so most trials are considered "errors." While simple in concept, the prevailing economic model is flawed. This Article is a theoretical inquiry into the selection criteria of settlement and trial. It applies principles of financial economics to construct a pricing theory of legal disputes. In addition to probability and transaction cost, dispute risk must capture the concepts of weight of evidence, variance of case disposition, and confidence in assessment. In much the same way that cost of capital, a measure of financial risk, affects the valuation of firms, the risks associated with litigation and settlement imply a cost of resolution of which transaction cost is but one component. By focusing on transaction cost, the standard model underestimates true economic cost. Because the expenditure of transaction cost reduces uncertainty, transaction cost and risk adjusted valuation are in dynamic tension. Under this approach, settlement and litigation are different pricing mechanisms in the absence of market pricing and are imperfect substitutes operating in varying conditions of uncertainty. Accordingly, this Article rejects the normative axiom that litigation is inferior to settlement-a conclusion having broad policy implications in the administration of justice.

INTRODUCTION

This Article challenges the central tenet of the economic theory of legal bargaining-the normative superiority of settlement. For many years, law and economics scholarship has subscribed to the conventional wisdom that the valuation of a legal dispute is simply its "expected value," defined as the probability of judgment multiplied by the expected damage award.¹The selection of settlement or litigation is seen through the prism of transaction cost economics: If a probabilistic value of a lawsuit can be calculated, a settlement is better since litigants can save the cost of litigation. The idea is elegant in its simplicity, but elegance is not the measure of correctness of positive theory or persuasiveness of normative prescription. Despite the siren's call of efficiency, settlements are rejected and cases are tried. In the search for an explanation, the common theme has been an "error" of some sort

(of judgment, perception, or strategy). This proposition is now axiomatic.²

The hostility to litigation is manifest. Trial has been described in such colorful terms as a "disease"³and a "pathological event."⁴

It is easy to see how litigants find themselves at trial due to miscalculation. Cases do not settle early when transaction cost savings would be the greatest. They settle in mid-litigation when previous settlement attempts, on roughly similar terms, have failed. Still many others settle late when most transaction costs have become sunk costs.⁵Common explanations are error, strategic behavior, or optimism.⁶Human failing is a convenient explanation for many things gone awry. Viewed in the unflattering light of the standard economic theory, the enormous legal and judicial infrastructure supporting the institution of civil litigation is a monument to economic waste.⁷Human error and irrationality certainly explain some observations, but beneath the apparent plausibility of these conventional explanations, there is an undercurrent of doubt: is there a systematic selection process or valuational concept that explains the apparent irrationality of litigation, settlement behavior, and ultimately the choice of trial? The normative aspiration is that participants should assess the probability of outcome (an exercise in the prediction of legal decisions), calculate the expected value, and settle on a valuation that should have converged absent "optimism."⁸This Article questions whether this economic theory prescribes rational behavior or wishful ideal.

This Article argues that the standard economic model overstates the case for both human error and prescience. The model assumes a degree of impossible rationality by implying both the existence of an objective ex ante probability of the decision standard and the ability of the parties to find it. The impossibility of accurate predictions of uniquely human events cannot be assumed away for convenience of economic theory.⁹The standard model misstates the applicability of expected value and the overarching consideration of transaction cost economics. This Article proposes an alternative economic theory of legal bargaining-a pricing theory incorporating the risks associated with settlement and litigation. It adopts the microeconomic cornerstones of utility (value) maximization, cost-benefit analysis, and rational choice, but goes further to apply financial economics to determine the true economic cost of uncertainty (risk).¹⁰The academic discipline of financial economics fundamentally deals with "the valuation of cash flows that extend over time and are usually uncertain."¹¹Since settlement and litigation involve the disbursement of cash flow under conditions of information imperfection and uncertainty, the academic discipline of financial economics is most relevant to a theoretical discourse on legal bargaining. Yet until recently, there has been little interdisciplinary application of the valuational techniques of finance theory to bargaining problems.¹²

Under the pricing theory proposed here, litigation can offer a cheaper cost of resolution than settlement. This statement is counterintuitive only if the cost of resolution is seen as a cash or cash equivalent outlay, like transaction cost in litigation. But if the cost of resolution is seen in the broader context of valuation, then it is intuitive that litigation can be cheaper under certain pricing conditions, and thus preferred. This Article posits that any given disputed claim has a cost of resolution, which is the total economic cost of dispute risk. The governing condition of a lawsuit is the uncertainty of outcome. Yet risk is not captured in the notions of probability and expected value, which simply measure the expectation of outcome but not its riskiness. A risk-adjusted valuation must incorporate the concepts of weight of evidence, confidence in assessment, and variance of case disposition from expectation. The conventional cost-benefit analysis ignores these factors and overstates the importance of transaction cost surplus.

Litigation is not an obsolete substitute for settlement, but an imperfect one.¹³The two involve different risk profiles and cost implications. Certainly litigation involves greater transaction cost, but settlement is not cost free either. While many have asked, "What is the cost of litigation?," few have asked the less obvious but equally important question: "What is the cost of settlement?"

Contrary to conventional thought, settlement is not an arbitrage proposition where the selection of certainty over risk is cost free; settlement can be as much of a gamble as trial. Like the cost of equity in the valuation of firms, the cost of settlement is not as apparent for it is imbedded in the valuation. A risk- based valuation model explains many apparently irrational behaviors: for example, reluctance to settle early when transaction cost savings are the greatest, "eleventh-hour" settlements when such savings are mostly depleted, and (some would say) decisions to go to trial. Seen through the prism of the standard analysis, these decisions seem irrational, or at least questionable. But if principles of financial economics are considered, apparent "errors" may be simply rational choices in the face of dynamic uncertainty. The fundamental problem is one of a coherent pricing scheme in the absence of market pricing.

This Article seeks to provide a balanced view of the complexities of the selection between settlement and litigation within the framework of economic efficiency. The current environment is one of public, governmental, professional, judicial, and academic hostility toward litigation, and particularly trials, as a method of...